It is assumed that each country or region produces a product which is an imperfect
substitute for the products of other regions. This allows us to formulate import equations of
the following form for each individual country
IMt = Snt ' (PCt / 30, )σ (C, + Gt + I, ) (29)
Imports of each country are a function of total domestic demand defined as private and
public consumption and total investment and relative prices expressed as the ratio between
the domestic consumption and the import price deflator. The coefficient σP is the price
elasticity. To capture possible lagged adjustment of imports to price changes the relative
price variable appears as a distributed lag of up to 4 quarters. The income elasticity is
restricted to one, i.e. we attribute all trend changes in the import share Sn to structural
developments such as increased trade integration between countries and regions
Consistent with our specification of imports we define exports of each region as
EXt = (wp;st / (з; / e, ))σ WDEMt (зо)
where 3; is the export deflator, :3;S a competitors price index (in dollars) and :'(0 is
an indicator of world demand. Competitors prices for each country are constructed as a
weighted average of import prices where the weights denote the share of the individual
exporting country in total imports of the importing region. World demand for an individual
country is defined as a weighted average of total imports with the weights representing the
share of the exporting country in total imports of the importing country or region. Also for
exports we allow that they respond sluggishly to changes in relative prices, so that there will
be a difference between short and long run price elasticities. The coefficient of the world
demand variable is constrained to one.
The current account is the trade balance plus transfer payments and interest rate
receipts/payments from net foreign assets. The evolution of net foreign assets F, is also an
endogenous variable in the model, modeled as the accumulation of current account balances
Ft =(1 + и ))-1 + EXt - I0ι + 175ι (31)
where NTRt is net transfers received from abroad.
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